Everyone knows that it's highly un-Foolish to try to predict the markets. However, is it also un-Foolish to "value" the market, to measure an implied level of risk, and then adjust your portfolio accordingly? I don't think so. In that vein, allow me to draw on some fundamental truths that exist in our market right now.
Fact one -- On November 26, the Dow Jones Utility index hit a high of 238.96.
Fact two -- Four days later, interest rates on the 30-year Treasury bond bottomed at 6.31%.
Why do I mention these two things in tandem? For those who may not be familiar with utility companies, they are very highly leveraged. In other words, they borrow lots of money all the time. So, the relative strength of a utility's earnings and dividends will depend on how attractive lending rates are. If rates are expected to go lower, utilities generally do well because it is expected that they will be able to borrow money at better rates, saving interest expenses, which allows them to pay higher dividends instead.
As a general rule, the stock prices of utilities and interest rates move in opposite directions. As rates move higher, utility stock prices generally fall lower. How is this relevant to you as an investor? Well, in the last four trading days, interest rates have backed up a full 25 basis points, from 6.51% to 6.76% on the 30-Year bond. Utilities, not surprisingly, have fallen as well.
How does this affect the general stock market?
In my opinion, the relative risk of the stock market can be measured in two ways: from a liquidity standpoint and a valuation standpoint. If one uses a simple YPEG, it is clear that the market, as measured by the popular averages, is overvalued. Estimates on the DJIA for next year stand at $432.00. The historic market Price/Earnings multiple is between 13 and 14. It is reasonable, in times of normal earnings, to expect that fair value might fall between a 13 and 14 PE.
Given this scenario, the market, as measured by the Dow, would be fairly valued in a range between 5616 and 6048. At 6567, it can be argued that this index is overvalued by between 8.5% and 17%. Now, assuming you accept the premise that the market may be slightly overvalued here, how does liquidity look? For a better perspective on this, let's quote our friend Macrodata from the Economy & Markets folder in Fooldom on January 5:
<<In the past two weeks the total assets of taxable money-market mutual funds, as reported by the Investment Company Institute, declined sharply from $772 billions to $759 billions. The stock market held at 748 on the S&P 500 Composite Index, down slightly from 749.
The ratio of liquidity to stock-market capitalization remains within the normal range, but now stands well below the median of that range. There would seem to be adequate liquidity to support the stock market somewhat below the current level.
Despite Friday's sharp rally in the stock market, investors should adopt a more cautious attitude pending further clarification of liquidity trends.>>
Everyone knows that one of the major reasons for the market rallying so much in the past few years has been the massive influx of money into the U.S. domestic markets. Rightfully so! Earning have expanded wonderfully and we have some of the best companies in the world. Our economy has been great, rates have been steady, with low inflation.
At some point, this will change. But to what degree? Who knows?
So, with rates rising recently, liquidity declining, and the market being arguably overvalued, where does this leave you, the individual?
Should you pull all of your money out of the markets and wait for the "big one" to pummel Wall Street and bring the financial world to its knees? Nope.
Should you borrow money on your house and buy large quantities of Put options waiting for the "end?" Nope.
Conclusion:
All of this means that you should begin to learn to deal with the concept of risk. You should be able to look at things like liquidity, courtesy of Macrodata (read back in the Economy & Markets folder for some great education), and do simple valuation techniques like a YPEG and gauge relative risk.
Are you on margin to the hilt? Are you speculating on short-term movements in the market with next month's rent money? Is any of this prudent?
Is it time to value all of the stocks in your portfolio to see if they are worth holding, regardless of whatever profit or loss you already have with them?
We all saw some of those high-flying momentum stocks get crushed this past summer. Do you own stocks without understanding why you own them? Time to revisit your reasons?
I'll let you decide these things for yourselves, Fools. What I know for sure is that everyone can benefit from "perspective."
Take care,
David